Sunday, April 2, 2017

Caught in the Web of Finance? When Network Connections Are Missing

Following the news can give the impression that the world of
business, and finance especially, is very well connected internally and to
other sources of profits. As of March 16, the still-understaffed Trump
administration had hired five people from Goldman Sachs, and coincidentally,
Goldman has reported that increased trading has helped its quarterly profits
increase more than threefold. Simultaneously
and unrelated to this, billionaire investor Carl Icahn, who now advises the
president on deregulation, has seen his shares in his oil refinery increase
significantly in value (oil refineries are regulated because of their pollution
and climate effects).

So is finance a web that entangles everyone? Not really.
Goldman Sachs is special because the bank has and exercises market power, which
in turn helps attract network ties. Icahn’s role is, well, a bit more
personalized and complicated. In general, though, finance is an industry that
competes like any other industry, and network ties among its firms adapt to
competitive concerns. This is why a paper in Administrative Science Quarterly by Pavel I. Zhelyazkov nicely
shows how networks have systematic gaps both in finance and other industries.

To start, networks connect because introductions and
friends-of-friends connections help firms find trustworthy and capable partners
when they want to execute complex tasks that are too big for one firm alone.
This is the logic driving networks tie formation. The same logic of why ties
are formed helps explain why ties do not form, leading to gaps in the network.
First, the need for firms to find trustworthy and capable partners means that
connections are premised on success – friends recommend their good friends, not
the cheats and failures they know. Second, the use of ties to help share tasks
means that connections are not made to strong competitors, because they might
just take the entire business away. In fact, for close competitors the more
capable are the ones that should be avoided the most, because they could take
away a big portion of the business.

So does this logic hold? The study looked at venture
capitalists seeking investment ties from private equity limited partners, which
is an interesting tie because venture capitalists look for promising firms to
invest in, and private equity is a big pool of money. They work together, and
they work on a complex task of finding good prospects and helping them succeed.
Venture capitalists do form networks that interconnect them and private equity
partners, as one would expect if venture capitalists who have some past
connection also make introductions. But also, as expected, these ties are
formed exactly when there is past success and absence of low competition – past
failures or current competition create gaps in the network.

So are the venture capitalists the normal kind of network
builders, or are investment banks like Goldman Sachs normal? Arguably the
venture capitalists are normal, because they deal with uncertainty and
competition, which are constants in business. Centers of power, whether
economic or political, play by different rules than the rest of the world.